Passive stock exchange traded funds generally follow a simple formula to reflect the performance of an underlying benchmark Index, but not all Indices are created alike. The varying indexing methodologies can generate different returns.
Most ETFs use a type of indexing or passive investment methodology that adjusts the weightings on component holdings within its investment portfolio to reflect that of an underlying index. Additionally, fund providers may use a sampling technique to select a few securities from an overall Index.
The majority of stock-related ETFs employ a market-cap weighted methodology where each stock component is weighted by their market capitalization in the original index.
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However, this methodology is heavily influenced by its top 10 holdings, which may make it more vulnerable to a market crash. Still, this is may be a boon when larger companies are outperforming the markets or during momentum driven market conditions.
The equal weighting methodology tries to balance out the top heavy nature of market-cap weighted indices, equalizing the weightings on all component holdings.
Consequently, mid- and small-cap stocks have a greater say in the fund, which help drive equal-weighted ETF performances during the initial stages of a market recovery. Additionally, historical evidence has shown that over the long run, mid- and small-cap companies tend to perform better over extended periods.
However, equal-weight ETFs will have to rebalance more frequently to achieve its target objective, which may increase the costs of holding the funds.
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